Sunday, April 13, 2008

Enhance Stock Investment Return via Option Selling

Long term investors could produce increased return (or lessen the same amount in losses) from selling call options. The concept of derivative trading may intimidating some learning investors, just read on and I will show you why this works and carries very-low risk.

Call-Option Basics

A Call-option gives you the right, not obligation, to purchase the underlying stock at the strike price; a Put-option does the opposite but right now we only take interest in Calls. Each option contract (according to CBOE regulation) carries 100 shares of the underlying stocks.

So, trading 1 contract of IBM Call-option gives you the right to purchase 100 shares of IBM at the strike price before the option contract expires (usually 3rd Friday of expiration month). The value of traded option contracts is termed the “premium”, the price that option buyers pay, and option writers receive.

(The most renowned option exchange today operates at CBOE, Chicago Board of Option Exchange. They provide a brief and concise primer on options. Spend half an hour on it and you will understand all the fundamentals.)

Out-of-money Call-Options

The option “money-ness” describes the relationship between the strike price and underlying value. For Call-Options, this means a strike-price higher than the underlying price, e.g. holding an IBM call-option contract with strike at $110 while IBM sells at $105/share. The premium decreases to zero for out-of-money options at expiration.

Writing Out-Of-Money Call-Options

When you write a contract of Calls, you become obligated to sell 100 shares of the underlying stock at strike price IF assigned (this happens randomly, and infrequently according to statistics). This naturally requires tremendous risk management if you do not own shares of the underlying. However if you do hold sufficient underlying stock positions (i.e. covered), this tactic could prove very worthwhile.

Detailed Example

Let’s say you own 100 shares of QQQQ (closed at $44.28 on 4/11/08). You could consider selling a contract of Calls with strike price ≥$45 expiring in May. Last quoted Bid for a $45 Call stands at $1.16, and you decide to write 1 contract.

The following possibilities will ensue for the 3rd Friday of May.

1. QQQQ lowers in value to say, $41/share, and you lose $328 on the ETF position and the options expire worthless. Due to premium gained on the written Calls; you reduce that loss by $116.

2. QQQQ remains at the same price of $44.28, and you made no return on the stock position, and the options expire worthless. With the premium earned, you make a risk-free profit of $116, roughly 2.6% of the underlying position.

3. QQQQ increases to say, $48/share, and you gain $372 on the ETF position, lose $300 on the written option position (IF assigned), and end with a net profit of $72. Yes in this case your profit could become lower; nevertheless it is still about “taking profit”, not a loss.

So, this scheme reduces risks and increases your probability of success (2 out of 3 net-profitable potential scenarios), and you can pull it off easily. Pretty good, huh!

1 Reflections:

alexandroid said...

Thank you for a good example. I could never figure out before how writing options can be useful.

The catch here of course is that CBOE options are American-type so it is not the price on 3rd week of May matters but any time from option writing till the expiration day. The longer time before the expiration, the more the probability of the case #3 to happen at any time due to the market volatility.

Stock can be kept for the periods when prices go against you, but with option written down, if prices go against you, it will be assigned for execution and "fixing" the losses immediately.